Australian Real Estate Debt Markets Observed

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1 Technical PAPER Australian Real Estate Debt Markets Observed The Demand for Longer Duration Debt in Australia > There has been a seismic shift in the source of capital for recent A-REIT borrowings as institutional borrowers go in search of longer duration debt to match the long term nature of the assets they hold. The growth in popularity of both the domestic medium term note market and the US Private Placement market demonstrates the demand for longer duration debt from Australian borrowers a need that the banking market is currently unable to meet. > At the same time, the demise of the Retail Mortgage Trust lenders and the inactivity in the CMBS market has reduced the range of potential providers of real estate debt in the Australian market, opening the door for life company and pension fund lenders. > The opportunity for longer duration debt capital sources to enter the Australian market is now greater than ever, but the question remains as to how this demand will be met going forward. The last five years have seen a significant dislocation in the supply and demand for institutional grade real estate backed debt in Australia. The Australian Lender Landscape The Australian commercial real estate lending market has been dominated by the large domestic banks since the life company lenders such as AMP and National Mutual exited the domestic market in the late 980 s. Despite having a long history in the local market, the increased lending competition following the deregulation of the Australian banking market in 98 followed by the severe real estate downturn in the late 980 s derailed life company commercial real estate lending in Australia. Through the 980 s and 90 s, retail mortgage trusts became significant lenders into the commercial real estate market. These trusts raised capital from retail investors for their lending activities. However, the practice of offering investors the ability to redeem at short notice while lending to borrowers for years (or more) was eventually going to create a liquidity issue. As a result of the sharp increase in redemption requests triggered by the financial crisis the majority of these trusts have been frozen and are not undertaking any new lending as they use capital from maturing loans to pay out investor redemption requests. These trusts have gone from having approximately AU$ billion of mortgages in 006 to less than AU$0 billion today, and are continuing to shrink. The CMBS market experienced significant growth from the late 990 s to have peak outstandings of AU$ billion in 007. Unlike other mature CMBS markets, Australian CMBS is typically low leverage, single borrower issuance but without the support of investment bank conduits and institutional investor support it has rapidly shrunk to be virtually non-existent at total outstandings of just AU$0.7 billion. In contrast, the unsecured lending market including REIT Bonds, medium term notes (MTNs) and the US Private Placement (USPP) market has grown substantially over the last five years from AU$6 billion of outstandings in 007 to AU$ billion today as borrowers seek diversification from the banks and seek longer tenor loans. Unfortunately for most owners and investors of real estate in Australia, this market is only available to highly credit rated borrowers. The vast majority of these debt capital markets products are arranged and placed by the banks also, further increasing their dominance. Property Investment Fitch Ratings National Australia Bank, Company Reports Important information: This technical paper has been prepared by the author and the Asian Association for Investors in Non-listed Real Estate Vehicles Limited (ANREV), to provide you with general information only. It is not intended to take the place of professional advice. In preparing this technical paper, the authors did not take into account the investment objectives, financial situation or particular needs of any particular person. Before acting on the information provided in this technical paper you should consider whether the information is appropriate to your individual needs, objectives and circumstances. No representation is given, warranty made or responsibility taken as to the accuracy, timeliness or completeness of the information contained in this technical paper. ANREV will not be liable to the reader for any loss or damage as a result of the reader relying on this information.

2 Change in Lending to Institutional Grade Commercial Real Estate Debt AU$Bn $0.00 $.00 $0.00 $.00 $0.00 -$.00 -$0.00 -$.00 -$0.00 Retail Mortgage Trusts CMBS Pension Banks Bonds & USPP Source: Property Investment, AFMA, Standard and Poor s, Fitch Ratings All of this dislocation has led to the large Australian banks having a greater share of the commercial real estate lending market than ever before. The demise of the CMBS and Retail Mortgage Trust lenders has seen the range of available lenders become even more limited in Australia. This is in significant contrast to the US market where there is a wide range of lenders participating in both the public and privately placed real estate debt markets. United States and Australian Lenders Institutional Grade Commercial Real Estate Debt Market Share ($ local currency) United States (US$.8T) Banks, S&Ls Life Companies CMBS REIT Unsecured Pension Australia (AU$8B) Banks Retail Mortgage Trusts Pension REIT Unsecured CMBS Public Untraded Mortgage REITs Govt Credit Agencies Source: Emerging Trends in Real Estate, Property Investment, AFMA, Standard and Poor s, Fitch Ratings More recently we have seen the emergence of pension funds entering the privately placed first mortgage lending space with lending by pension funds increasing from zero in 008 to approximately AU$. billion today. Given the shrinking pool of alternate lenders, Quadrant believes there is an opportunity for pension funds and life companies to enter the Australian first mortgage lending market today and establish a durable, long term market share. As sophisticated capital markets like those of the United States have shown, just as there are different demands for debt capital (short term vs long term, highly structured vs flexible terms, high leverage vs low leverage, fixed rate vs floating rate, diversified sources of capital vs single relationships, revolving facilities vs fully drawn) there are different investment objectives for debt providers. The Australian real estate capital market s needs cannot be satisfied by the domestic banks alone nor should the banks be expected to be the cheapest and/or most appropriate source of capital for all real estate capital needs. A robust debt capital market should have the capacity to match borrower requirements for duration, flexibility, capacity, leverage and loan structure from a range of sources including banks, unsecured bonds, CMBS, nonbank lenders and life companies and pension funds and it is encumbered upon the property industry, both borrowers and lenders alike, to explore, develop and support long duration debt products in Australia. Quadrant Estimates

3 The Demand for Long Duration Real Estate Debt Income producing commercial real estate of institutional quality is a long dated asset class. Properties owned in Australia by the listed real estate companies (A-REIT s) and unlisted real estate trusts (wholesale funds) are generally held for periods of 0 years or longer. Institutional grade assets are largely funded via a combination of both debt and equity. While the leverage level varies, the higher quality vehicles do not usually exceed leverage of 0% loan to value ratio (LVR); however, current levels are much lower at circa 0% 0% LVR 6. In times of perceived prosperity (as seen before the financial crisis) LVR s are increased in order to drive growth and in theory return on equity. The prudent use of leverage to increase equity returns is a sound investment thesis; however, where the structure and, more particularly, the duration of that leverage does not suit the underlying asset, capital management issues quickly emerge as was the case during 009. Given the current dominance of the Australian lending market by the major banks, the prevalent lending terms and conditions are a construct of what suits the banks internal capital funding model. This is characterised by short duration ( year) floating rate lending as opposed to the long dated nature of the underlying real estate asset. Playing by the bank s lending rules of short duration and tight lending covenants allows the banks to provide their most competitive pricing, but does that suit the long term investment objectives of the property owner? While short term floating rate debt capital is a mismatch to the long dated nature of real estate assets, Australian borrowers are conditioned to receiving short term floating rate loans from the banks as the banks have been the dominant providers of first mortgage loans for the last years. The Global Financial Crisis (GFC) forced almost all investment vehicles to attempt to reduce leverage largely due to maturing debt exposures and/or breaching tight Interest Cover (ICR) or LVR covenants within their banking facilities. In the private wholesale vehicles this was achieved by a combination of asset sales and additional equity contributions from existing investors. In the public market this was achieved largely by massively dillutionary capital raisings in the first instance followed by asset sales. Neither outcome was a good experience for investors in these vehicles. The short duration of the Australian commercial real estate lending market in effect means that each year a significant proportion of the total outstanding commercial real estate debt of a REIT or wholesale fund needs to be recapitalised. This is manageable provided debt capital is always available; however, events during the GFC have well and truly shaken this core belief. As a result, those borrowers that have been able to access longer duration debt (mainly restricted to the large, credit rated REIT s and wholesale funds) have looked to do so wherever possible. This trend is evident in the weighted average debt maturity profile of Australian REIT s which has been extended considerably from.7 years in 008 to. years currently 7. Australian REIT s Debt Maturity Profile (AUD) $.00bn $0.00bn $0.0bn $8.00bn $6.00bn $.0bn $6.60bn $7.0bn $.90bn $.00bn $.00bn $.0bn $0.00bn FY FY FY FY6 FY7 FY8+ Source: JP Morgan IPD Australia, Property Investment, QREA Estimates 6 National Australia Bank 7 JP Morgan

4 The question is why haven t Australian institutional real estate owners and investors been more aggressive in adopting more appropriate capital management strategies and lengthened their debt maturity profile as much as possible? The answer is complex and multidimensional; however, we believe there are three main contributors to this short term borrowing behaviour: ) The Australian banks dominate the market and short term lending suits their internal funding model (i.e. is more profitable); ) There is a relative lack of depth and maturity in the real estate securitisation and bond markets, partly for historical reasons and partly because the banks compete heavily in this space to ensure they are not disintermediated: and ) The pressures of A-REITs and funds quarterly reporting cycles combined with the optimistic view that debt will always be available and only get cheaper induces investors to obtain the lowest cost finance possible, not necessarily the most suitable. In response to the lack of longer dated debt capital in Australia many AREITs have chosen to pursue offshore debt capital markets with the most notable being the USPP market. This market has proven to be a happy hunting ground for AREITs as they seek to extend their Weighted Average Debt Expiry (WADE) profile with 7, 0 and even year tenor, noting that the traditional Australian commercial real estate lenders have been unable to satisfy this borrower demand. The USPP market is a USD denominated borrower market and for many prospective borrowers it is a relatively well known and understood process with a high degree of pricing and term certainty. Many Australian only entities (i.e. non US asset owners) who have chosen to go to the USPP market have then fully hedged the USD borrowing back to AUD in order to mitigate currency risk. However, this currency hedging has been done at considerable cost which is not always included in the quoted coupon rate making direct cost comparisons difficult. There is clearly a market for long(er) duration AUD denominated debt capital (as evidenced by this demand in the USPP market) where borrowers are clearly prepared to pay a premium to obtain the desired duration. In addition to the USPP Market and, with a rapidly shrinking CMBS market, the larger credit rated borrowers have turned to the issuance of bonds and medium term notes (MTNs) with approximately $. billion of MTNs issued in the last twelve months 8. Of this recent issuance more than 0% was year duration and only 8% was 0 year duration notes and all issuers were rated BBB+ or better. The demand for longer duration funding is illustrated in the debt capital raising activities of the A-REIT s over the last two years as shown in the chart below. Australian REIT s Source and Duration of New Debt Capital (AUD) $M 6,000,000,000,000,000, / 0/ Bank Facilities Non-Bank Debt capital Avg Duration (RHS) Yrs Source: JP Morgan 8 JP Morgan

5 As such, there is enhanced scope for new non-bank lenders to enter the market and provide an alternate and diversified source of capital for real estate borrowers, particularly 7 and 0 year duration loans. Nonbank lenders (including pension fund investors and life companies) are starting to emerge as an alternate source of debt capital, albeit they are only minor participants at this stage. A recent report by Deloitte Access Economics 9 put forward the concept of low equilibrium in relation to the institutional investor participation in the Australian debt markets. By comparison with other developed economies, Australia has both a small corporate bond market and a low pension fund allocation to fixed income assets. Deloitte found that neither low demand nor low supply by itself is responsible for the current low equilibrium outcome in the market. Rather, both demand and supply interact to produce the current low levels of non-bank involvement in the commercial real estate debt markets. Accordingly it is our view that the increasing levels of demand from borrowers for longer duration institutional capital will inevitably lead to an increase in the supply of capital from pension funds and life companies into the market. As the supply increases, demand will further increase creating a deeper more liquid domestic market for real estate debt investments. The Opportunity for Institutional Investors The opportunity for institutional investors (particularly pension funds and life companies) to meet this demand for longer term debt capital is evident. These longer duration loans would provide institutional investors with long dated, low volatility returns from the same domestic underlying real estate assets and cash flows they would normal invest equity in but with capital being deployed more conservatively in a secure first mortgage position. Prudently deployed privately placed real estate loans are underwritten in much the same way as a direct equity investment (with a significant amount of property due diligence undertaken reviewing leases, outgoings, capital expenditure, leasing markets, valuations, building condition, etc) theoretically making the step from equity investing to debt investing relatively straight forward. These privately placed mortgages are usually able to be priced wide of bond issuance due to their more flexible structures and wider borrower base thereby providing a premium over fixed interest bond investments. Due to the long dated nature of real estate leases and the significant equity capital buffer provided by the borrower, a pension fund or life company lender should enjoy a relatively high income return with a strong capital preservation position and low volatility. This report contains the commentary and opinions of Quadrant Real Estate Advisors LLC ( Quadrant ) and Quadrant makes no representation or warranty in relation to the accuracy, completeness or reliability of the information contained herein. This report is not intended to be an exhaustive statement on the financial instruments, issuers, markets or developments herein referred to. The analysis contained in this report is based on numerous assumptions. Different assumptions could result in materially different results. This report does not constitute or form a part of, and should not be construed as an offer to sell or solicitation of an offer to buy investments or any fund and does not constitute any form of commitment or recommendation on the part of Quadrant. Investments offered and/or solicitations will be made only through a confidential private offering memorandum subject to at all times to revision and completion. Each recipient should consult its own legal counsel, tax advisor and other appropriate consultants as to the business, legal, tax and related matters concerning an investment advisory relationship with Quadrant, but not limited to, the risks associated with investing in any Private Placement. Quadrant is an Australian Securities and Investments Commission (ASIC) Foreign Registered Corporation (ABN ) and United States Securities and Exchange Commission (SEC) Registered Investment Advisor. This presentation does not form part of, nor should it be construed as an offer or solicitation of any offer to buy investments or any fund. Any offer when made by Quadrant would be made under ASIC Class Order Exemption number 0/00. Under Class Order Exemption number 0/00 Quadrant is exempt from the requirement to hold an Australian Financial Services Licence (AFSL) in respect of any offer to wholesale investors. For further details; Stephen O Keeffe sokeeffe@quadrantrea.com Quadrant Real Estate Advisors LLC 9 Deloitte Access Economics, Domestic Fixed Income Assets in Australia, Oct 0